What Is Promote in Private Equity?
Unpack 'promote' in private equity: the performance-based compensation model for fund managers, crucial for aligning their interests with investor returns.
Private equity pools funds to acquire and manage companies, aiming to grow their value before sale. A central compensation component is “promote,” which is key to understanding financial incentives in this field.
Understanding Promote in Private Equity
Promote, also known as “carried interest” or “carry,” is a share of private equity fund profits paid to the General Partner (GP) or investment manager. This performance-based compensation differs from regular salaries or operational fees, aligning fund managers’ interests with Limited Partners (LPs), the capital providers. Promote incentivizes the GP to maximize returns, as it is only received if the fund performs well and generates profits for LPs.
The investment team, including partners and senior professionals, typically receives promote. These General Partners actively manage investments from identification to exit. Their promote compensation directly ties to the fund’s investment success, ensuring a shared objective with Limited Partners.
Key Elements of Promote Calculation
Promote payment to the General Partner is determined by mechanisms in the fund’s governing documents, like the Limited Partnership Agreement. These ensure Limited Partners receive a return before the General Partner earns profits. The first mechanism is the hurdle rate, also known as the preferred return.
A hurdle rate defines a minimum rate of return that Limited Partners must achieve on their invested capital before the General Partner can begin to earn promote. This rate, often set between 6% and 10% annually, functions as a protective measure for investors, ensuring they recover their initial investment and a baseline profit first. Once the fund’s performance surpasses this predetermined threshold, the General Partner becomes eligible to receive their share of the profits.
After the hurdle rate is met, capital and profits are distributed via a “waterfall distribution.” This multi-tiered structure dictates how investment proceeds are shared between LPs and the GP. A common sequence returns initial capital to LPs, then pays their preferred return. Next, a “catch-up” tranche may allow the GP to receive a larger profit share until their promote percentage is achieved. Finally, remaining gains are split, typically 80% to LPs and 20% to the GP. While specific terms vary, the principle is a structured payout prioritizing LP returns.
Clawback provisions are a safeguard for Limited Partners in promote calculation and distribution. A clawback requires the General Partner to return previously distributed promote if, by the fund’s termination, LPs haven’t received their agreed-upon profit share. This protects LPs if early profitable exits lead to promote payments, but later underperforming investments cause the fund to fall short. The clawback ensures GP compensation aligns with the fund’s long-term performance, requiring repayment for overpayments.
Promote and Other Private Equity Compensation
Beyond promote, private equity firms also receive management fees. These annual charges, paid by Limited Partners to the General Partner, cover the fund’s operational expenses. This includes salaries for the investment team, office space, and costs for due diligence and ongoing portfolio management.
Management fees are calculated as a percentage of committed capital or assets under management (AUM), ranging from 1.5% to 2.5% annually. Unlike promote, these fees are paid regularly, often quarterly, regardless of the fund’s investment performance. Management fees ensure the private equity firm sustains operations even before successful exits generate profits.
Promote is performance-based compensation, a share of fund profits paid only upon successful exits and investment liquidation, after certain return thresholds. Management fees, conversely, are asset-based, covering operational overhead, and are paid regularly throughout the fund’s life cycle, independent of investment performance. Promote incentivizes profit generation, while management fees ensure the firm’s operational continuity.
Taxation of Promote
For recipients, promote, or carried interest, realized from portfolio company sales, is treated as long-term capital gains for tax purposes. This preferential treatment applies if certain holding period requirements are met. Under current tax law, assets must be held for more than three years for gains allocated to investment managers as carried interest to qualify for long-term capital gains rates. Gains from assets held for three years or less are taxed as short-term capital gains at ordinary income tax rates.
Long-term capital gains treatment is more favorable for individuals than ordinary income tax rates. The top federal long-term capital gains rate is 20%, while the top ordinary income tax rate can reach 37% through 2025. A 3.8% Net Investment Income Tax (NIIT) may also apply to certain net investment income, including capital gains, for higher-income taxpayers. Promote’s specific tax implications are complex, varying by individual circumstances and fund structure. This information is for general understanding; professional tax advice should be sought for specific situations.